At Risk Reward — The Long Term Incentive



Long term incentive plans in listed company environments are predominantly associated with the granting of a future right to a share, subject to performance over a defined period, and they differ and are separate from other share based plans such as the $1,000 tax exempt plan, salary sacrifice and share acquisition plans, and are increasingly confined to the most senior staff in an organisation. This will vary depending upon the organisation’s scale and its maturity.

Considerations in Equity Plan Design

When approving equity based incentive programs in today’s governance environment, the challenge facing Boards is to balance the retention and motivation of key executives and staff with the need to demonstrate a clear alignment between employee participation and enhancing shareholder value.

The following table sets out the key questions which need to be addressed in developing an equity based long term incentive program.

Design Consideration - Table 1

What is granted?

Recent research reveals that the most common instrument in use among the ASX top 200 listed entities is a share or performance right. Options are often used in organisations with a significant growth profile or in combination with share rights and in this context will often have variable performance hurdles.

What is the frequency of awards?

The most prevalent approach to LTI allocations across the broad market is an annual allocation in overlapping cycles (3 below). The single cycle and sequential cycles (1 & 2 below) are used in the main for CEO and key executive allocations where there is a fixed term contract or a large sign-on grant of equity. The single cycle grant is often used to offset the containment of fixed remuneration and cash based incentives, providing a leveraged incentive opportunity aligned to shareholder interests and the realisation of the business potential.

The overlapping cycle reflects a business as usual approach allowing for an LTI holding to be built up over subsequent year allocations, retaining the retention value of the allocations which will vest progressively rather than at a cliff date. Annual allocations also give the Board the flexibility to adjust both individual allocation values and also the employees participating in LTI from year to year as well as the performance hurdles attached to each allocation.

LTI - Table 2

What are the performance conditions?

A performance hurdle consists of:

An evaluation period, usually two to five years, during which the performance of the company is measured or assessed. The commentary which follows is confined to measures for company performance.

A performance measure which provides an objective measurement of the company’s performance. The choice of the measure is made on the basis of the elements of company performance which it is desired to make the focus of executive action and on the kind of measure which can be readily and effectively communicated to employees and shareholders.

A benchmark or target against which the measurement is compared. This can be the historical performance of the company itself or some external measure such as the performance of similar companies (peer companies).

A relative or absolute measure. A company may be required to achieve a specific goal such as an 10% cumulative improvement in share price (an absolute comparison) or a comparative goal such as equal or exceed the share price performance of 30 peer companies or the constituents of an S&P/ASX index (a relative comparison).

In the prevailing listed company market, the dominant performance measures are Total Shareholder Return (TSR) and Earnings Per Share (EPS), these are defined as follows:

Total Shareholder Return (TSR) is a measure of the annualised return on investment of a hypothetical $1000 in a company’s ordinary shares. Bonus shares are held, rights are sold on the first day of trading and reinvested in the underlying security, dividends are reinvested in the underlying security at the end of month price following each ex-dividend date, no brokerage fees are included in the return calculation. In short, all capital gains and dividend payments over the period under consideration are incorporated. The return per annum is based on a twelve monthly compounding rate.

Earnings Per Share (EPS): The relationship between earnings and the number of shares issued is calculated as the net profit (operating profit after income tax) divided by the number of ordinary shares on issue. EPS represents a measure of a company’s performance. It should however be kept in mind that a growth in earnings may not represent improvement in a company’s operations. The ratio is usually expressed in cents per share.

Other measures applied in varying settings include return measures (which are generally absolute) or internal measures which generally relate to meeting milestones which shareholders are aware of and which influence their initial or continuing investment. Illustrative of return measures would be return on capital employed, return on total assets, return on shareholders’ equity, return on investment.

Among Australian companies a relative TSR hurdle is the most popular. A typical TSR hurdle is one that compares the companies TSR performance to a selected index with 50% vesting upon the company’s TSR meeting the median TSR of an index’s constituents. The vesting then increases on a straight basis to provide 100% vesting upon achieving a 75th percentile TSR rank or better.

The EPS or Return hurdle (ROCE, ROE, ROI) is more aligned to management’s line of sight and less exposed to externally influenced factors, whereas TSR is the critical measure for institutional investors in the marketplace.

Among listed companies there is increasing precedent in Australia for the adoption of dual hurdles, for example, a TSR performance relative to an appropriate index in combination with an absolute EPS hurdle with 50% vesting on the basis of each hurdle. This changes the risk profile of an allocation by allowing a portion of an allocation to vest on the basis of outcomes within management’s control and is isolated from a relative comparison to the external market.

Threshold, Target & Maximum

Whereas annual incentive plans will often embrace a construct of threshold, target and maximum, long term incentive plans do not embrace that construct in incentive value terms.

Nominally, the threshold construct would relate to the minimum performance required in relative or absolute terms before any benefit arises from the granting of equity aligned securities under an LTI program. The value of that benefit however is entirely determined by the state of the market at the time either all or a proportion of securities vest.

The construct of a maximum also exists in that when the stretch or highest hurdle required to be met under the LTI program is achieved, the entire award vests though its value is unknown at the time of the award grant and is entirely dependent upon prevailing market conditions.

Equally, in this context, many executives are unable to exercise their rights under a long term incentive plan arising from share trading policies where they are well-informed individuals and are only able to exercise their rights under an LTI program during approved trading windows which may not reflect the share price at the time the hurdle is first met. Further, under a significant number of long term incentive plans, participants have a period of time after the performance conditions are met to exercise their entitlements at which stage the market value can be significantly at variance with the market value at the time the performance hurdle was first met.

In our judgement the use of threshold, target and maximum in the context of a long term incentive plan is not appropriate as a remuneration construct. The construct of threshold entitlement which relates to achieving a performance standard does have value as does the construct of a maximum entitlement though these constructs of entitlement have no meaning in terms of the remuneration value of the award at the time threshold or maximum performance hurdles are met.

When do grants vest?

Among the ASX 100 companies the predominant vesting period for securities is three years. There are some vesting schedules which provide proportional vesting over a four year period with vesting commencing two years from the grant date. The structure of the vesting period over four years either reflects an equal proportion for each vesting date such that an award is divisible into three tranches vesting a third, a third, a third after the second, third and fourth anniversaries of the grant date. An alternate to this strategy under the three tranche structure where there is a back end load is that tranche one consists of 20% of the securities in the grant, tranche two 30% and tranche three 50%.

Other vesting periods adopted would be those which spread the vesting and periods over which performance is measured out to five years. These vesting periods might embrace proportional though equal vesting at the end of the third, fourth and fifth years from grant date or a vesting schedule which has some vesting prior to three years and some vesting after three years, such as a vesting schedule covering the second, third and fourth anniversaries of the grant date.

Progressive vesting schedules will often have provision for unvested securities arising from a failure to meet the performance hurdle being rolled up into subsequent tranches, though without the benefit of retesting at the end of the fourth or fifth year.

Valuation of Securities

A further issue is the requirement to expense securities granted under long term incentive plans. There has been variability in the treatment under accounting standards of externally benchmarked return hurdles compared to earnings or absolute share price growth hurdles which require more regular adjustment on the basis of the probability of equity granted vesting following progressive disclosure of company performance.

The value of allocated equity to executives will nominally be influenced by the valuation of the instrument. Egan Associates have commented on issues arising from valuation in earlier newsletters:

In a future Newsletter we will discuss share appreciation rights plans, warrants and cash based LTI plans, as well as management incentive plans operating within Investment Banks, Funds Managers and Private Equity investee entities.

A further newsletter will also address the myriad of issues which arise when documenting plan rules and ensuring compliance with corporate regulations, taxation and listing rules as well as the issues which arise in relation to monitoring performance and determining entitlements.

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